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It is no secret that equity markets enter bubble phases which are then followed by long bust phases. The bubble phases tend to be the most dangerous, as investors tend to lose a significant part of their wealth when these bubbles burst and enter a prolonged bust phase. These bubble periods are marked by a distinct behaviour known as ‘Irrational Exuberance’ – a term popularised by the Nobel Prize winning American economist Robert J Shiller in his seminal book
Irrational Exuberance.

In his book, the author argues such euphoric phases characteristically show an unfounded optimism in the market, lacking any real foundation of valuation or economic parameters. Needless to say, Shiller has been successfully making the right calls in periods of irrational exuberance.

The current market conditions, marked by a sharp increase in the asset prices in the equity markets without being impacted by stringent lockdowns, are challenging the notions of irrational exuberance once again.

Shiller suggests using the Cyclically Adjusted Price Earnings (CAPE) ratio to measure the irrational exuberance. The 2006-07 period is generally considered one of such irrational exuberance, during which the CAPE had shot up beyond the normal parameters. This was then followed by the Global Financial Crisis, which almost collapsed the financial system before the US Federal Reserve intervened.

Indian Shiller PE 2005-2021

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US Shiller PE 1980-2021

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In the context of Shiller PE, India is trading at 1x standard deviation above the mean, while the USA is trading at 1.8x. This does not pose a significant challenge, as there is a change in the earnings trajectory for the market.

Earnings growth has improved significantly as product prices have moved up on account of supply-side constraints and the resulting inflation. This justifies a higher Shiller PE as the earnings trajectory has also moved up. In the pandemic year, Nifty delivered a 15% earnings growth and the earnings trajectory is further improving.

Significant Improvement in NIFTY’s Earnings Growth Trajectory

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Improving earnings trajectory indicates that the optimism in the equity markets is not necessarily unfounded and is indeed backed by robust fundamentals, justifying the current market valuations.

Moreover, a closer look at valuations makes more sense when broken down across sectors. On a standalone basis, although the Nifty is trading at 2x standard deviations above the long-term mean, a breakup across sectors paints a different picture.

Half of the key sectors are trading at their mean valuations, while a few sectors that are trading above the mean (such as IT) are justified because of the sectors’ significantly improved growth trajectory and visibility.

Nifty and Nifty Sectors valuations

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Valuations at this juncture are still reasonable, especially when viewed across sectors and factoring in the underlying fundamentals of the sectors. With metals, PSUs, banks and infrastructure still trading closer to their mean valuations of the last ten years, they continue to offer further headroom for valuations to rise.

Considering the broad parameters of valuations, the underlying earnings growth, and still strong fundamentals, we are yet to enter the zone of irrational exuberance.

However, it is critical for the fundamental factors to sustain. Balance sheets of major companies have improved. Major banks such as SBI, ICICI, Axis, and others are in a much stronger position than they were a couple of years ago which is also helping the valuations.

Overall, the zone of irrational exuberance is some distance away, but it does not mean that the market is not heading in that direction. While the fundamentals are supporting the market at this juncture, it may be easily carried away and the zone of safety may be breached irrevocably.

As these scenarios unfold rather quickly, it is imperative to keep tabs on the fundamentals even as the markets have become more efficient. In conclusion, do remember nobody has lost wealth by booking profits when there is too much greed in the market.

Irrational Exuberance: Are we near the Shiller mark that can trigger pain?

By ariox